The story of the current financial crisis is well-known now and much has been written. Indeed, we’re now at the point where many observers are indicating that the crisis is now at an end. It would seem that the immediate financial sector impacts are leveling off, but in many countries the economic recovery will likely take a long time. However, a number of emerging markets have come out of the crisis in relatively stable shape. China is the most prominent example. In fact, one might say that China is having a “good crisis” in certain ways as it has lifted its prominence – it is the one large country seen as leading the world out of this global crisis. The same applies for China’s financial system given that many of its banks are now the largest in the world and (at least on the surface) posting strong performance.

The crisis certainly hit China hard in the last quarter of 2008 and into 2009, especially the export-oriented sectors of the economy. However, the spillover to the financial system and banks in particular has been minimal thus far. The impact of the crisis has been mainly muted by three key related factors:

loose monetary policy keeping interest rates at a 20 year low and injecting liquidity into the markets; and

$1.1 trillion in new bank loans issued in the first 6 months of 2009 (largely due to the first two actions above).

Based on data from the People’s Bank of China, 45% or about $480 billion of the $1 trillion in new lending through mid-2009 was done by the State-owned Commercial Banks. These banks make up the majority of the banking system in China. It appears that the money went mainly into fixed assets, such as infrastructure, but also into real estate.

Click chart to view larger version.

So, is all of this new credit leading to asset bubbles in the real estate and stock markets? Well, it’s not entirely clear whether the asset bubbles are due to bank lending, but some estimates are that 20% or more of all new lending, or $200 billion, has gone into these sectors. As the graphs below show, there have been rapid rises in stock and real estate prices that began at about the same time as the lending boom, so it sure does look as if there is a link here...

Click chart to view larger version.

So far this looks like a “good crisis” for the banks in China, even in the face of such rapid rises in asset prices, decreases in corporate profitability, and declines in exports. Besides simply coming out of this global crisis as the largest banks, Chinese banks also are posting strong performance. Non-performing loan (NPL) ratios have actually declined during this period of crisis from 2.5% at end-2008 to 1.8% by mid-2009.

However, there are a number of reasons for concern in the banking sector, including: rapid growth into an ailing economy; narrowing interest margins; an implicit assumption of government backing of new loans for “stimulus projects,” even if it is not there; continued challenges in credit risk, internal control, and governance practices; and legacy issues – state-directed lending resulted in about $400 billion in NPLs earlier this decade. In fact, a news article not long ago pointed out that much of the bad debts from the past have yet to be resolved and instead have been rolled over, and one recent observer stated that this legacy, plus the possibility of new NPLs, may be a “ticking time bomb.”

We have already talked on this blog about the potential for problems in the banking sector, and although the banks may be able to manage a significant degree of losses, it is very likely that government support would be needed if any losses start accumulating fast. The public policy issue then becomes the trade-off between supporting the financial sector versus other public expenditure needs. The common prescription for China now is to move toward a more innovative and consumption- and service-oriented economy. But this requires more spending on better education, health, and social safety net systems. This may not be as feasible if there are substantial losses in the financial system that requires a public bailout. As we are now seeing in the US, the massive bailout of financial institutions has limited flexibility in terms of options for the various health care reform plans.

But, if China can continue to grow out of the crisis at 8% or more for the next few years while the US and Europe recover from the crisis, maybe none of these concerns will be realized. The banks can simply grow out of the problem and declare this global crisis a minor bump in the road. Time will tell.